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Following certain default events,<ref>Exactly ''which'' defaults will depend on the contract: under an {{isdama}} it will include Events of Default and Potential Events of Default, but not Termination Events or Additional Termination Events — which, given the “culpability” of [[ATE]]s, is something of a dissonance in itself.</ref> a “[[flawed asset]]” provision allows an innocent, but [[out-of-the-money]] counterparty to a {{tag|derivative}} or {{tag|securities finance}} transaction to suspend performance of its obligations ''without'' terminating the transaction and thereby crystallising a [[mark-to-market]] loss implied by its out-of-the-money position.  
{{quote|
{{d|Flawed asset|/flɔːd ˈæsɛt/|n}}
A “[[flawed asset]]” provision allows the “innocent” party to a financial transaction to suspend performance of its own obligations if its counterparty suffers certain default events ''without'' finally terminating or closing out the transaction. Should the defaulting side cure the default scenario, the transaction resumes and the suspending party must perform all its obligations including the suspended ones. For so long as it ''not'' cured, the innocent party may close the Master Agreement out at any time, but is not ''obliged'' to.}}


The defaulting party’s asset – its right to be paid, or delivered to under the transaction – is “flawed” in the sense that it doesn’t apply for so long as ''the [[conditions precedent]] to payment are not fulfilled''.  
====Rationale====
{{drop|W|hy would a}} party ever want to ''not'' close out a defaulting counterparty? It all comes down to ''[[moneyness]]''. The “[[The bilaterality, or not, of the ISDA|bilaterality]]” of most derivatives arrangements means that either party may, net, be “[[out of the money]]” — that is, net across all outstanding transactions, would ''owe'' money, if all transactions were terminated. This is a notional debt that is not “due” as such, so it is money a solvent counterparty might not want to have pay out just because its counterparty has failed to perform its end of the bargain. On the other hand, the innocent counterparty doesn’t want to have to continue stoically paying away to a bankrupt counterparty that isn’t reciprocating.  


The most famous flawed asset clause is Section {{{{{1}}}|2(a)(iii)}} of the {{isdama}}. It entered the argot in a simpler, more peaceable time, when two-way, zero-threshold, daily margined {{tag|CSA}}s were a rather fantastical sight, and it was reasonably likely that a counterparty might be nursing a large unfunded mark-to-market liability which it would not want to have to fund just because the clot at the other end of the contract had gone belly-up. Closing out the contract would crystallise that liability, so the flawed asset provision allowed that innocent fellow to just stop performing the contract altogether, rather than paying out its [[mark-to-market]] loss.
The flawed asset provision allows the innocent party the best of these both worlds. It can stop, and sit on its hands, thereby not thereby crystallising the [[mark-to-market]] loss implied by its [[out-of-the-money]] position. The defaulting party’s “asset” – its right to be paid, or delivered to under the transaction – is “flawed” in the sense that its rights don’t apply for so long as ''the [[conditions precedent]] to payment are not fulfilled''.  


That was then; 1987; they hadn’t even invented the {{csa}}. Even once they had, it would be common for a muscular [[broker/dealer]]s to insist on one-way margining: “You, no-name pipsqueak highly [[Leverage|levered]] [[hedge fund]] type, are paying ''me'' [[variation margin]] and [[initial margin]]; I, highly-capitalised, prudentially regulated<s>, [[Balance sheet|balance-sheet]] [[Leverage|levered]]</s><ref>Amazing in hindsight, really, isn’t it.</ref> financial institution, am not paying ''you'' ''any'' [[margin]].”
Conceivably you could invoke a flawed asset provision even if you were [[in-the-money]], but you would be mad to.
=====Which events?=====
Exactly ''which'' default events can trigger a flawed asset clause will depend on the contract. Under an {{isdama}} it {{{{{1}}}|Events of Default}} and even {{{{{1}}}|Potential Events of Default}}, but not {{{{{1}}}|Termination Event}}s or {{{{{1}}}|Additional Termination Event}}s — which, given the “culpability” and “event-of-defaulty-ness” of [[ATE]]s, is something of dissonance in itself.


Well, those days are gone, and bilateral zero-threshold margin arrangements are more or less obligatory nowadays, so it’s hard to see the justification for a [[flawed asset]] provision. But we still have one, and modish post-crisis threats by regulators worldwide to stamp them out seem, some time in 2014, to have come to a juddering halt.
=====Collateral=====
 
Flawed assets entered the argot in a simpler, more peaceable time when two-way, zero-threshold, daily-margined collateral arrangements were a fantastical sight. It was reasonably likely that a counterparty might be nursing a large unfunded mark-to-market liability which it would not want to have to fund just because the clot at the other end of the contract had blown up. This is a lot less likely in these days of mandatory regulatory margin. Nor did it occur to dealers, who typically insisted on the flawed assets clause, that they might be on the wrong end of it. The events of September 2018 were, therefore, quite the chastening experience.
One can level many criticisms at the flawed assets concept these days, and the [[JC]] does. Not only is it often triggered by vague, indeterminate things, there are many cases where its technical application makes absolutely no sense. Really, if a counterparty doesn’t like the position it is in when a counterparty defaults, its remedy is simple. Close out. Just saying “talk to the hand” really ought not do in these enlightened, margined times.

Revision as of 14:53, 28 April 2024

Flawed asset
/flɔːd ˈæsɛt/ (n.)
A “flawed asset” provision allows the “innocent” party to a financial transaction to suspend performance of its own obligations if its counterparty suffers certain default events without finally terminating or closing out the transaction. Should the defaulting side cure the default scenario, the transaction resumes and the suspending party must perform all its obligations including the suspended ones. For so long as it not cured, the innocent party may close the Master Agreement out at any time, but is not obliged to.

Rationale

Why would a party ever want to not close out a defaulting counterparty? It all comes down to moneyness. The “bilaterality” of most derivatives arrangements means that either party may, net, be “out of the money” — that is, net across all outstanding transactions, would owe money, if all transactions were terminated. This is a notional debt that is not “due” as such, so it is money a solvent counterparty might not want to have pay out just because its counterparty has failed to perform its end of the bargain. On the other hand, the innocent counterparty doesn’t want to have to continue stoically paying away to a bankrupt counterparty that isn’t reciprocating.

The flawed asset provision allows the innocent party the best of these both worlds. It can stop, and sit on its hands, thereby not thereby crystallising the mark-to-market loss implied by its out-of-the-money position. The defaulting party’s “asset” – its right to be paid, or delivered to under the transaction – is “flawed” in the sense that its rights don’t apply for so long as the conditions precedent to payment are not fulfilled.

Conceivably you could invoke a flawed asset provision even if you were in-the-money, but you would be mad to.

Which events?

Exactly which default events can trigger a flawed asset clause will depend on the contract. Under an ISDA Master Agreement it {{{{{1}}}|Events of Default}} and even {{{{{1}}}|Potential Events of Default}}, but not {{{{{1}}}|Termination Event}}s or {{{{{1}}}|Additional Termination Event}}s — which, given the “culpability” and “event-of-defaulty-ness” of ATEs, is something of dissonance in itself.

Collateral

Flawed assets entered the argot in a simpler, more peaceable time when two-way, zero-threshold, daily-margined collateral arrangements were a fantastical sight. It was reasonably likely that a counterparty might be nursing a large unfunded mark-to-market liability which it would not want to have to fund just because the clot at the other end of the contract had blown up. This is a lot less likely in these days of mandatory regulatory margin. Nor did it occur to dealers, who typically insisted on the flawed assets clause, that they might be on the wrong end of it. The events of September 2018 were, therefore, quite the chastening experience.

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